iPass is a telecommunications services company that has built a global network providing mobile workers access to Internet connectivity and home office enterprise software. Unlike facilities-based providers, iPass has assembled a “virtual network” by aggregating connectivity with hundreds of ISPs, hot spot aggregators, mobile data providers, and other telecom service firms worldwide.  The company, founded in the late 1990s, has recently been undergoing a shift in their business from providing their customers access via dial-up modems to broadband access. With operating leverage working (temporarily) in reverse, the company has been unprofitable for over a year. However, profits will return within one or two quarters. Management will earn incentive compensation in 2008 only if EBIT margins exceed 11% (14% in Q4 08) on $200 million of broadband and software revenue.  If they hit these targets, which we believe are achievable, we expect $27.6 million of free cash flow in 2008 (NOLs will protect the company from paying taxes), and an equal or higher amount in 2009, as operating leverage and sales growth offset the return to full taxation. We believe the stock is worth north of $9.00, implying 45% annual returns if it takes two years for our thesis to play out. Cash on hand represents 28% of the market cap.

 

 

The best way to understand the company’s service, and its value proposition to customers, is to consider a brief before-and-after case study of a typical user’s experience.

 

Jim is a traveling salesman for a Fortune 1000 company in California. He spends 10 days a week on the road, traveling to different countries. While he is traveling, he needs access to his email, calendar, contacts, enterprise applications (Siebel CRM, Oracle database, etc), and he needs all this access to be secure. While email and calendar functions are relatively easy to access over the web, enterprise applications are difficult and require VPN (virtual private network) services. More importantly, Jim needs to access the Internet and his enterprise applications from multiple locations, in multiple countries, and via multiple technological platforms in his typical 10 days a month of travel. On one trip, he might need to log in from his hotel in Vancouver, from the Tokyo airport, then again from a 3G mobile data network in Tokyo, and finally over an Ethernet connection at a conference center in Shanghai over a network provided by a state-owned carrier. Without iPass, Jim would have to establish accounts with each provider in turn, pay for expensive day passes that usually show up in the travel budget (opposed to the IT budget where they belong), and trust that the network access providers in foreign countries, many of them small and unknown, provide the same level of security and trust as does the local Internet provider back home in California. In addition, Jim would have to store multiple login/password combinations, most likely on his laptop, which would invite hacking should his laptop be lost or stolen.

 

With iPass Mobile Office, Jim creates a single account with iPass. At his Vancouver hotel, or in the airport in Tokyo, or over the 3G and landline connections that he would have to use on his trip anyways, Jim is able to obtain Internet access – and more importantly, log into his enterprise applications via VPN – without needing to establish usernames and passwords with each carrier. He also does not pay for this access if the network provider has a deal with iPass. If he is off the iPass virtual network, he can still log on, though the savings are not as great.

 

With iPass, Jim’s IT department now manages its mobile workers’ need for connectivity with a single global provider, instead of aggregating 550 carrier relationships, as does iPass, around the globe. In addition, iPass bundles device management software that allows for remote application loading, minimum OS compliance, remote provisioning of security patches, and other centralized IT functionality. Interested analysts can get a better idea of the various uses for iPass software by reading company case studies at http://www.ipass.com/company/company_casestudies.html.

 

 

The company was highly profitable until they went through their recent technology transition – here are the financials since 2003:

 

 

As you can see, opex has increased dramatically in recent years, let by network access and network operation growth. Network access refers to fees that iPass pays to its network partners for iPass customer usage on those physical networks. Two factors explain the growth here. First, higher customer counts and higher usage drive network access, so this is largely a variable cost that will respond to customer growth. However, access costs have grown faster than customer growth

 

 

 

 

 

 

 

 

This has happened because broadband today is a lower margin business than dial-up access. Dial-up, a commodity access service that is long past its prime, was available for aggregation by iPass at very low prices, as carriers viewed any incremental revenue from iPass users as a great way to milk a dying cash cow for a few additional bucks. But broadband has been different. It’s still a growth business for most carriers, with customers new to broadband access representing the biggest source of growth. It’s highly differentiated by technology and features, which is not necessarily evident in the home access market but is vitally important for mobile and corporate users. And it’s one requiring significant annual capex for providers as they support more subscribers and faster, richer Internet experiences for those subscribers. In addition to those factors, iPass has for much of the past few years had a far smaller broadband user base to offer its network service providers, thereby offering little in terms of incremental revenue or usage to encourage more favorable pricing. Thus, it’s no surprise to see the recent trend in network access costs as a percentage of revenue.

 

Going forward, there are reasons to believe that network access costs may be topping out. First, iPass recently raised prices for customers on variable usage plans and began the process of renegotiating its access agreements with its 550+ global network service providers. These renegotiations, based on the greater broadband volume that iPass is now able to bring to the table, should result in lower costs than iPass has been getting recently. In the second quarter, iPass succeeded in a major renegotiation with their largest 3G mobile data provider in the US, driven by iPass’s ability to bring incremental revenue at no acquisition cost for the carrier. In essence, iPass enables carriers to fill their networks to capacity at low cost now that they are achieving scale in their broadband channel. Combined with the price increase, these moves should improve margins within a few quarters for iPass.

 

Looking out towards the long-term, there are reasons to believe that broadband access is no different from dial-up Internet access when it comes to margins for virtual service providers like iPass. Eventually, the facilities-based carriers will saturate the market, reducing the need for growth capex and making customer churn the only large source of growth and market share change among carriers. Incremental traffic from the mobile iPass customer base should be attractive to carriers facing this situation, especially since they are infrequent users requiring little capex to support. And competition continues to increase – by 2010, customers should be able to get broadband access from their Baby Bell, from their cable company, from their electric utility, from dozens of local telecommunications companies, from their wireless carrier, from specialty mobile broadband companies like Clearwire, and others. It’s logical to assume that the market will remain fragmented, which ensures that a key part of the iPass value proposition – multi-network interoperability – will remain in intact, as will iPass’s bargaining power relative to its network access suppliers. Thus, I view the current network access costs as a percentage of revenue to be peak levels that are likely to come down over time, possibly even to the historical levels of 2002 – 2004.

 

The network operations line refers to the company’s data center and remote login server costs. As with network access costs, network operation costs are at an historic high of 18.0% of revenue. The company expects that these costs will remain relatively stable over time, which is a reasonable assumption, but there does appear to be the possibility of some improvement as the company essentially turns off the portions of its infrastructure that support the dial-up business.

 

 

R&D and SG&A are the other major line items in opex for iPass, and both are slightly higher than a few years ago, as a percentage of revenues. This increase is almost entirely attributable to the 2006 acquisition of GoRemote Software, which expanded iPass’s offering into remote fixed broadband access. None of these line items are likely to increase as a percentage of revenue from current levels, and there may be some room for improvement as iPass management exercises discipline in restraining costs here, especially in the acquired GoRemote segment, where revenue can likely grow faster than costs for some time.

 

2007 Management incentive comp plan and the Shamrock factor:

 

In early 2007, the company undertook some executive compensation decisions that are noteworthy for the signals they send about both future profitability and corporate governance at iPass. Most importantly, iPass chose not to reprice management options that were significantly underwater (average exercise price of $7.96), a significant decision for a company that went public at $25 per share. Secondly, the board did not refresh option grants for 2007 and 2008.

 

In February, 2007, a new performance share plan was put in place. It’s described as such in the proxy:

 

In February 2007, the Compensation Committee decided to not grant restricted stock to NEO’s and instead grant only stock options and performance shares. The stock options vest in 2009. The performance shares, if earned in 2008, will vest on February 28, 2009. Fifty percent of performance share awards are earned upon achievement of $200 million of broadband and software services revenue in 2008, 25% are earned upon the achievement of non-GAAP operating income goal of 11% for the full year 2008, and 25% are earned upon the achievement of fourth quarter 2008 non-GAAP operating income goal of 14%. These goals were established consistent with the goal of migrating from the historic dial business to a broadband and security business.

 

The company insists that $200 million in non-dial revenue and 11% margins constitutes guidance from the company. But in our experience, we have rarely seen a board of directors or a management team put in place an incentive compensation plan that they thought was out of their reach. In addition, management has been unusually good about forecasting results even as their business has shifted dramatically in the past few years, which gives us more confidence in the company’s ability to hit their 2008 targets for compensation. With 80% of new business being written on the enterprise flat rate pricing scheme that was rolled out recently, management has excellent visibility to future sales and margins, which makes the management compensation targets highly believable to us.

 

These compensation decisions were not made in a vacuum – iPass has had much input from 14.7% holder Shamrock Capital, a noted activist fund run by Michael McConnell and investing funds on behalf of the extended Disney family.

 

Shamrock made its first investments in iPass in the spring of 2005, at an average price of $5.30. Additional investments were made in 2006 at prices up to $7.50, such that we estimate Shamrock’s average price to be in the $6.00 range. Thus, Shamrock is significantly underwater in this two year investment, but they have not sold any shares as far as we can tell. In the July 2007 issue of Value Investor Insight, Shamrock claimed 25% annual returns since 1984. Even more interesting, they publicly stated one of the most audacious claims we’ve ever read in print by a money manager – in the November 2006 issue of something called Dealmaker magazine, McConnell insisted that the firm had “never lost money on a deal.” We have no idea what this means, but we have reviewed Shamrock’s track record as is available to scrutiny in 13D filings, and it is impressive.

 

We do not invest in companies simply because one famous investor or another is in the stock; nor we suspect, do most VIC members. However, we believe that it’s a material event when a shareholder with a multi-decade history of improving both capital allocation and corporate governance wins board seats at an underperforming company. That’s the current situation at iPass, and that’s why we believe the Shamrock involvement to be a material, positive catalyst for iPass investors. We feel very confident that iPass will make capital allocation decisions that continue to benefit shareholders – like the recently completed $30 million stock buy back – guided by the Shamrock directors.

 

Let’s run through a few exercises to see if the management targets for 2008 and 2009 are reasonable. First, here’s a table of broadband and software revenues over the past 10 quarters:

 

 

 

 

 

 

Next generation revenue is currently growing at 51% annually and on a run rate of $117.2 million. If we project this growth rate for 2008, we get the following revenue projections:

 

 

 

 

 

 

 

 

 

 

 

Clearly, to get to $200 million in next generation revenue, iPass will have to increase revenue growth back up to the levels posted in the past few quarters. But achieving this does not appear unrealistic. The company boasts 99% customer renewal rates, and a high number of corporate customers with relatively light user penetration. Indeed, much of their growth is coming today from increasing their user base within accounts that they have already won, and penetration across departments within companies of their user base. The ongoing shift in the pricing model, which has moved from usage-based early in this decade, to monthly user fees in recent years, and now to enterprise-wide flat rate pricing, reduces uncertainty for IT departments and should lead to even greater usage of the iPass network.

 

In addition, the recently-announced price increases could push the company past its $200 million goal. All it would take would be 8% price increases starting in Q1 to move revenues from $185 million to over $200 million.

 

As for margins, the company would have to reduce SG&A, R&D, and network operations costs by small amounts each, and network access by a large amount, to achieve the 11% EBIT margin target. Admittedly, we have no idea as to whether iPass can achieve this goal by the end of 2008 (and the 14% EBIT margin by the 4^th quarter of 2008), but over the long term, we are very confident in the company’s ability to post operating margins in this range, based on the margins the company achieved in the past. In 2003 and 2004, when iPass was generating less than half the revenue it will generate in 2008, the company achieved 16.4% and 17.4% GAAP EBIT margins. Achieving non-GAAP (excluding stock options expensing…this is a tech company, after all) 11% and 14% operating margins should be well within reach for a company twice the size it was five years ago.

 

So, if we take the management incentive comp minimums as financial targets, our projections for 2008 and 2009 are as follows:

 

2008:

 

Next gen revenues: $200 million

EBIT margin: 11%

EBIT: $22 million

 

Plus:

Amortization: $11.1 million

 

EBITDA: $33.1 million

 

Minus:

Capex: $5.5 million

 

EBITDA-capex: $27.6 million

 

EBITDA-capex is about what free cash flow will be in 2008, since the company will pay no taxes thanks to its NOLs. Add in $3.4 million of interest income, and the company will generate $31 million in 2008. This is before giving any credit to decaying dial revenues, which will be low in volume but high in margin in 2008.

 

Looking to 2009, we again assume no dial revenues. We further assume that broadband and service revenues will grow 35%, which represents a decline in the growth rate from the current quarter’s 51%. We feel that this number is achievable, given the underpenetration of virtual network services for global 2000 companies and the opportunity for iPass to continue getting more revenue within the companies for which it already has accounts. We are assuming 14% margins, based on the management target for 14% EBIT margins in the 4^th quarter.

 

In 2009, we assume  

 

Next gen revenues: $270  million

EBIT margin: 14%

EBIT: $37.8 million

 

Plus:

Amortization: $12.5 million

 

EBITDA: $50.3 million

 

Minus:

Capex: $7.0 million

 

EBITDA-capex: $43.3 million

 

If you prefer to look at net income, we can start with $37.8 million of EBIT and assume a 35% tax rate, we get $24.6 million in net income from operations (excluding interest income). If we value that net income at 20X, appropriate for a fast growing tech company that leads its niche, and uses almost no tangible capital (cash and intangibles make up 75% of total assets), we get a value of $492 million. Add in the current $81 million of cash, plus the $31 million generated in 2008 and we have a total company value of $604 million. Divide by 62.3 million shares outstanding, and we reach a stock target $9.70 by the middle of 2009.

 

Risks:

 

Carrier dominance: The more dominant a carrier or ISP in its country, the less need there is for iPass services. However, we believe this to be a very minimal risk to iPass. Much of their business is generated by companies whose employees travel internationally, and we see little prospect for cross-border mergers of major telecom firms, especially since home country politicians would look askance at any deal to take out a national telco, which are often state-run or at least objects of national pride.

 

Changing technology: Certainly, the move from dial-up to broadband has forced iPass to adapt. But we believe that any future technology change will benefit iPass, as the proliferation of Internet access technologies, as well as the proliferation of ISPs, drives the need for providers like iPass that can unify and aggregate the various means of connection. Moreover, all new access technologies currently on the drawing board are simply extensions of the always on, broadband idea; there are none that are entirely new architectures, like broadband was to dial-up, reducing the risk of technological change to Ipass.

 

Slowing growth for mobile broadband and international travel: This may be a problem if oil prices spike and international travel is reduced temporarily as a result, but for this to be a long term threat, you’d have to believe that the century long trend towards increased travel, communication, commerce, and connectivity was about to reverse itself.